The Myth of the Business Cycle

ByRobert Skidelsky

The 'creative destruction' theory of boom and bust is no guide to today's economic turbulence.

Testifying recently before a United States congressional committee, former Federal Reserve chairman Alan Greenspan said
that the recent financial meltdown had shattered his "intellectual structure". I am keen to understand what he meant.

Since I have had no opportunity to ask him, I have to rely on his memoirs, The Age of Turbulence, for clues. But that book
was published in 2007 �" before, presumably, his intellectual structure fell apart.

In his memoirs, Greenspan revealed that his favorite economist was Joseph Schumpeter, inventor of the concept of "creative
destruction". In Greenspan's summary of Schumpeter's thinking, a "market economy will incessantly revitalise itself from within
by scrapping old and failing businesses and then reallocating resources to newer, more productive ones". Greenspan had seen
"this pattern of progress and obsolescence repeat over and over again".

Capitalism advanced the human condition, said Schumpeter, through a "perennial gale of creative destruction", which he
likened to a Darwinian process of natural selection to secure the "survival of the fittest". As Greenspan tells it, the "rougher
edges" of creative destruction were legislated away by Franklin Roosevelt's New Deal, but after the wave of de-regulation
of the 1970s, America recovered much of its entrepreneurial, risk-taking ethos. As Greenspan notes, it was the dot-com boom
of the 1990s that "finally gave broad currency to Schumpeter's idea of creative destruction".

This was the same Greenspan who in 1996 warned of "irrational exuberance" and, then, as Fed chairman, did nothing to check
it. Both the phrase and his lack of action make sense in the light of his (now shattered) intellectual system.

It is impossible to imagine a continuous gale of creative destruction taking place except in a context of boom and bust.
Indeed, early theorists of business cycles understood this. (Schumpeter himself wrote a huge, largely unreadable, book with
that title in 1939.)

In classic business-cycle theory, a boom is initiated by a clutch of inventions �" power looms and spinning jennies
in the 18th century, railways in the 19th century, automobiles in the 20th century. But competitive pressures and the long
gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually
profitable. Such over-investment produces an inevitable collapse. Banks magnify the boom by making credit too easily available,
and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Dennis Robertson, an early 20th-century "real" business-cycle theorist, wrote: "I do not feel confident that a policy which,
in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties,
or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial
to the populations concerned." Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved
both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary "real" business-cycle theory builds a mountain of mathematics on top of these early models, the main effect
being to minimise the "destructiveness" of the "creation". It manages to combine technology-driven cycles of booms and recessions
with markets that always clear (ie there is no unemployment).

How is this trick accomplished? When a positive technological "shock" raises real wages, people will work more, causing
output to surge. In the face of a negative "shock", workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by government is needed. Bailing out inefficient
automobile companies such as General Motors only slows down the rate of progress. In fact, whereas most schools of economic
thought maintain that one of government's key responsibilities is to smooth the cycle, "real" business-cycle theory argues
that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today's economic turbulence, or offers sound instruction about
how to deal with it. First, in contrast to the dot-com boom, it is difficult to identify the technological "shock" that set
off the boom. Of course, the upswing was marked by super-abundant credit. But this was not used to finance new inventions:
it was the invention. It was called securitised mortgages. It left no monuments to human invention, only piles of financial
ruin.

Second, this type of model strongly implies that governments should do nothing in the face of such "shocks". Indeed, "real"
business-cycle economists typically argue that, but for Roosevelt's misguided New Deal policies, recovery from the Great Depression
of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing all the wrong things in bailing out top-heavy
banks, subsidising inefficient businesses, and putting obstacles in the way of rational workers spending more time with their
families or taking lower-paid jobs. It reminds me of the interviewer who went to see Robert Lucas, one of the high priests
of the New Business Cycle school, at a time of high American unemployment in the 1980s. "My driver is an unemployed PhD
graduate," he said to Lucas. "Well, I'd say that if he is driving a taxi, he's a taxi-driver," replied the 1995 Nobel laureate.

Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern "real" successors
smothered his insights in their obsession with "equilibrium" and "instant adjustments". For Schumpeter, there was something
both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques
of his mathematical progeny.

Robert Skidelsky is professor of political economy at Warwick University.